The Rise of Regulatory Raj

Union finance minister Pranab Mukherjee with MoS NN Meena and his team waves to media at his office before leaving for Parliament House to present the annual Budget 2012-13, in New Delhi on Friday. PT

Updated: Sun, Mar 18 2012. 09 35 PM IST

It took the country 20 years to dismantle the licence-permit-quota raj instituted in the 1950s. Even before the rubble and remnants of that could be fully cleared, the foundations of a regulation-litigation-arbitration raj are being laid.

There is no fundamental difference between the two; the 1950s variant was about discretionary control and the 21st century raj is about discretionary regulations. Be it telecom, or taxation, mining or manufacturing, all sections and sectors are being impaired. What was a comparative advantage has been deftly converted into a huge disadvantage.

Union finance minister Pranab Mukherjee with MoS NN Meena and his team waves to media at his office before leaving for Parliament House to present the annual Budget 2012-13, in New Delhi on Friday. PTI

Not surprisingly, the 2012-13 budget has sought a record number of 25 retrospective amendments—more than any other Finance Bill ever. And, very significantly, the maximum number of amendments relate to the increasing the discretionary control of the Union government.

The issue is not only about the much discussed and more damned retrospective implementation to tax overseas transfer of assets a la Vodafone.

There are a host of amendments, retrospective as well as prospective, which have serious consequences of the nature of economic regime in India.

For instance, fraught with no less serious consequences is the proposal that use of or right to use computer software would constitute royalty with retrospect effect. For more than a decade now it has been understood that such income is business income and is not taxable. Similarly, the General Anti-Avoidance Rules provisions put the burden of proof on the taxpayer and give unbridled powers to the government on a highly subjective matter.

Another example of giving contentious, unnecessary and discretionary powers to the tax authorities is that in the case of closely held companies and domestic entrepreneurs who have sourced equity from venture capital funds and private equity. Not to speak of the harassment potential (and the implied corruption coefficient) of amendments to Section 149 of the Income-Tax (I-T) Act to allow reopening of I-T returns up to 16 years, from six years now.

The manner in which this is being done clearly shows that the legislative system is not respecting the legal system (e.g. the government not respecting the comments of the Supreme Court that certainty in tax laws is critical for foreign direct investment) and vice versa (e.g. the cancellation of the 122 telecom licenses). In a business context, a moment’s reflection will make it clear that these two—the legal system and the legislative system—which have been the biggest advantages India has had in the world of business are being seriously undermined and compromised.

It is a well-accepted fact that India’s institutionalized legal and legislative framework within which policy was being formulated gave it a huge comparative advantage over China which is struggling to find its way, with respect to the negotiation of agreements between foreign and domestic interests. The extent of freeness of trade in China appears to be still determined by specific zones, such as the so-called special economic zone that contains China’s economic engines of Hong Kong and Shenzhen.

As against this, it was universally accepted that an agreement with an Indian firm is guaranteed by the Indian legal system; there is recourse, at least in theory and more-or-less in practice, should a contract go awry. This is crucially relevant to business because trans-border contracts need to have legal heft. The process changes that are being brought about now and the manner in which this is being done threaten to disrupt the country’s economic framework.

This can have wider ramifications. This is because India as a vibrant democracy has, until now, provided comfort for investment so long as it is aptly underpinned by a robust legislative system and independent, but well demarcated, judicial system which is now becoming an imponderable.

Notwithstanding the larger and long term issues, at the very least what has already been done by these amendments in the Finance Bill, is to increase the risk perception about India. In the minds of the investors, both domestic and foreign, the sovereign risk on India, the country risk as it is called, has most certainly shot up in the last one year; first with the Supreme Court cancelling telecom licences and now with the numerous retrospective amendments. Within the country, all domestic firms will have to factor the uncertainty of a policy approval and the instability of a policy regime into their operation and not only their future investment decisions. That this will have implications on pricing and profitability should be obvious.

As far as foreign direct investment goes, even the trickle that was coming will be jeopardized as the foreign investors will have to factor in a higher country risk and seek a much higher return to justify that risk level. In other words, the risk-return profile of India as an investment opportunity has just been made a lot steeper; the slope of the risk return curve is becoming too can steep for investments to stick.

From the commanding heights of the control economy, India is now moving to the reverberating ravines of the regulated economy. Welcome back to the old babu raj in a new garb.

Haseeb A. Drabu is an economist, and writes on monetary and macroeconomic matters from the perspective of policy and practice. Comments are welcome at haseeb@livemint.com